Cost center is the smallest segment in which expenses are collected and reported to the management of an organization.
Cost center can be created based on different departments or based on company’s function.
Some cost centers are indirectly related to the company’s profitability i.e. they do not contribute directly to the profitability of the company. Followings are example of Cost Center that can be created within an organization based on the departmental structure of the company;
- Selling and distribution
- Human resource
You can create Cost Center within production department based on expenses and your business requirement.
Expenses can directly or indirectly be related to a Cost Center. If it’s directly related then such expenses must be posted to the cost center or else it has to be sent to other related cost centers based on the percentage of usage.
Why Cost Center are used in business
Management of companies wants to monitor expenses structure based on the type of expenses they incur and the impact of it on the profitability.
By doing this they tried to control the profitability level of the company.
To do this kind of analysis, they have to record expenses as per their internal requirements. General ledger accounts are created to record expenses in profit and loss accounts but those expenses are not properly apportioned to the products or departments.
In an organization we have different departments who takes the services of another department. To know profitability of such departments we need to assign these expenses incurred by one department to other departments.
Cafeteria is part of the administrative department who incur expenses for running different food outlets in an organization or providing lunch and dinner to employees. It also serves other food items on a daily basis.
Employees from different departments like production, finance, research and development, sales and administration use the services of cafeteria. At the end of the period if you want to analyze the profitability of your research and development cost center then the expenses of the cafeteria must be assigned to it (as a portion of cafeteria cost is related to research and development department).
To do this you need to create a cost center called “cafeteria” and at the end of the period transfer related expenses to research and development cost center based on number of employees using cafeteria.
What is a production cost center
Production cost centers are those which collects expenses related to a production process. For example: production cost centers collect expenses related to fuel, light, electricity etc used in production process.
What is non-production cost center
Cost centers other than production are called non production cost center. It includes sales and administrative, human resource and finance. These are not directly related to the profitability of the company and are treated as indirect expenses for the company.
Expenses like salary of administrative staff, selling and distributions are collected under these cost centers and at the end of the period these expenses are reallocated to production Cost Center to find out the exact expenses related to a product.
Cost center classification depends on the business requirement and the type of business you do. If you are into service industry then the structure will be different than a manufacturing industry.